US sequester: Global deflation club welcomes China as new member

The below graph reflects the relative performance of major equity indices since 2000. The economic growth histories of China and Korea have contributed to superior performance over the US and Japanese equity markets over this timeframe. However, the below graph reflects how sensitive Chinese and Korean markets are to US markets, as both China and Korea had significantly underperformed US markets during the 2008 crisis. While China’s and Korea’s equity markets have recovered from the 2008 crisis, they’ve not risen much in the past three years relative to the US market—and especially Japan since November 2012. This article considers the current economic circumstances surrounding the ongoing flatlining of China’s equity markets, and their implications for the future performance of Chinese equities.

US debt limits cool global economic growth

With the US government shutdown fear, investors focused on China’s markets will need to be wary of building inventory in China’s manufacturing sector. As noted in the prior article in this series, China’s producer price index (PPI) is still in negative territory—right around the levels seen since the dot com collapse in 2001–2002, though better than the double-digit negative numbers seen in 2009 during the global financial crisis. In Part 3 of the prior series on consumption, we see that the consumer price index (CPI) in China has also declined to 2.5%. Investors will need to be mindful of negative PPI data bleeding into and tainting the CPI data. Should that happen, China’s growth plans may end up taking a great leap backward until things “normalize.”

The new normal under US sequester

The new normal under US sequester will introduce a fairly widespread sense of uncertainty into global economic markets. US corporate profits have been humming along nicely since 2008, thanks in part to the unprecedented debt spending of both the US and European governments, as well as the unprecedented low interest rates provided by their central banks. The government sector has executed on its goal of supporting employment and consumption by stepping in for the private sector, which has still a way to go in recovering from the loss of purchasing power post-2008.

As the real data on unemployment suggests, despite the tremendous efforts of the Obama Administration and the US Federal Reserve bank, unemployment remains virtually unchanged post-2008 crisis. The US employment-to-population ratio has declined back to where it was before women entered the workforce in the 1970s. This ratio fell from just over 64% to just over 58% since the 2007 economic peak. With another percent or two of declines, this ratio will be back to the Ozzie and Harriet era levels. As far as employment is concerned, for the United States, it could be that our future is in our past.

All the king’s horses

As Market Realist analyst Xun Yao Chen points out, the poor labor market data, despite aggressive monetary policy measures, has failed to get the US consumer back to prior spending levels. Sprinkle in a decline in Federal deficit spending and, at least in the near-term, you’ll likely get an even greater decline in both consumption and employment data in the US. If all the king’s horses and all the king’s men in Washington couldn’t put the economic Humpty-Dumpty back together again, you have to wonder what the future will look like as fiscal austerity creeps into the US economy. Such economic trends have the ingredients required to eventually make an Arab Spring go global. Occupy Wall Street could end up with a second lease on life.

What does this mean for China?

The build-up of China’s inventories at home and on the shelves of Walmart is cause for concern. Should the budget fight lead to the loss of as many as 1,000,000 government jobs, simplistic math would suggest that US unemployment will reach record post-2008 highs, and the current decline in consumption in the US will pick up steam. Such a dynamic would suggest that the US is on its way back to the Rockwell era. In the case of China, this could lead to greater labor unrest for China’s dormitory-dwelling workers.

As a result, investors focused on China’s markets will have to exercise caution until confidence develops that low interest rates can support some recovery in employment and consumption in the more advanced economies, such as the US and Europe. Should the sequester debate drag on and economic strains intensify in the West, you might expect to see these issues manifest themselves in the export-driven economies of the East. For China, the sequester debate in the US could be just as critical for the average factory worker as it is in the US for the average government worker.

Outlook

For investors who think China can orchestrate a smooth deceleration in economic growth without significant disruptions to the banking system and also contain inflation, enhance productivity, manage investment growth, and grow domestic consumption, perhaps the weakness in Chinese equity prices over the past two or three years would present a more attractive price. China’s iShares FTSE China 25 Index Fund (FXI) is down roughly 15% from its November 2011 post-2008 highs. For China skeptics seeking to embrace the more recent economic trends seen in Japan and the United States, as reflected in Japan’s Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ), as well as the USA S&P 500 via the State Street Global Advisors S&P 500 SPDR (SPY) and Blackrock’s S&P 500 Index (IVV), the US and Japan markets may appear more attractive than China’s iShares FTSE China 25 Index Fund (FXI) and South Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further analysis as to why Chinese equities could continue to underperform Japanese equities, see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.”